Stock Buybacks and Motivation of Issuers : continued
Seeking Motivation in Capital Flow Analysis
Stock Buybacks and Motivation
There also is no question that to criticize buybacks as unethical draws strong objections from beneficiaries of the practice, and even from those who, although not beneficiaries, have been won over by pro-buyback arguments.
But to the capital flow analyst, ethics should be relevant:
- If behavior is unethical, even when not generally recognized as such, there is a possibility that perceptions may change and reactions may develop that modify behavior, effecting the balance of market forces.
- If unethical behavior is rarely mentioned in the press and an alternate reason is generally accepted as the explanation for price trends, this makes it difficult for the analyst, who is part of society, to perceive true motivation, resulting in misinterpretation of market forces.
Although Capital Flow Analysis shows that stock buybacks were the primary force driving equity prices upwards during the last two decades of the 20th century, the generally accepted explanation for rising stock prices has been simply that the intrinsic value of stocks has been improving and that, in an 'efficient market', prices reflect this.
An analyst who did not understand the role of buybacks in boosting prices in the years leading up to the new millennium, viewing the practice as a price-neutral form of dividends, would have missed warning signals for the Crash of 2000.
Reason for Caution
A word of caution is in order.
If you work for a large corporation, a major accounting or legal firm, or a big player on Wall Street, you may safely discuss results of level-one analysis around the company water-cooler — that is, simple descriptions of capital flow data.
However, discussions of level-two topics — motivation of market players linked to sociology, historical trends, and ethics — may be hazardous to your career
Your boss may not think highly of a suggestion that your company, clients, or their friends have improper motives.
Furthermore, in this litigious society, discussions of corporate motives in e-mails or company memos, even in general terms, may have unpleasant consequences.
Generally, you can describe level-two motivation and its effects on markets, without voicing your views regarding the ethics or appropriateness of such behavior.
For example, you might explain how corporate stock buybacks have driven up equity prices for a generation and may continue to do so until corporations can no longer finance the operation, without mentioning that you think that buybacks are improper.
Unless you own the firm, are independently wealthy, or are retired, ethical interpretations of level-two analyses are best restricted to close and trusted friends.
There is an online Capital Flows Forum on this site where you may debate anonymously issues related to Capital Flow Analysis and sector motivation.
[The Center for Capital Flow Analysis is independent and has no paid advertisements or sponsorship by market institutions. The author of the essays and lessons on this site is able to voice opinions without losing his job, but many might not be in a position to do this.]
Mutual Funds: Level-Two Analysis
As an example of 'motivation' — the reason that sectors act as they do — we can cite the relatively simple case of mutual funds.
When an investor purchases shares of mutual funds, he or she is making an asset-allocation decision; mutual funds are sold according to the type of assets in which their managers intend to invest.
When we buy a stock fund, we expect the fund manager to invest in stocks, not bonds or cash.
In other words, the reason that mutual fund managers buy stocks or bonds is simply that this is what they are programmed to do.
Like robots, fund managers must keep to the fund's 'fundamental investment policy' no matter what the fund manager may think about the future of the market for that particular type of asset.
If the stock market falls off a cliff, equity fund managers, like lemmings, will blindly follow.
The 'motivation' of mutual funds is obvious once it is stated baldly, as we have done.
However, nowhere in a mutual fund prospectus will you find the statement:
'We can be expected to behave like robots and will continue to blindly follow your asset-allocation decision no matter what.'
Nor will most fund prospectuses give you any substantial clue as to what the intrinsic value of equities may be at any particular time.
Furthermore, promoters of mutual funds will do little to dissuade the investor from the asset allocation assumptions that are implicit is choosing to invest in the fund.
All mutual funds offer a disclaimer from responsibility for loss, as well as information about past 'performance', expenses, turnover ratios, and other factual information mandated by the SEC, but few equity funds will tell you the weighted price-earnings ratio of the stocks they hold, the average cash dividend yield or dividend coverage, the typical leverage or current ratios of the companies in which they invest, or any other fundamental information about the value of the class of securities in which they suggest that you place your life savings.
Simply put, the motivation of promoters and administrators of mutual funds is to sell services of portfolio administration to investors who already have made a fundamental choice as to asset allocation.
How Do We Discover Motivation?
The question is, if mutual funds do not clearly reveal the motivation for their investment behavior, where do we find this information?
The answer is simple: we must deduce motivation from the objective facts of the matter — which is sometimes easier said than done.
The best advice we can give is the same that Hannibal Lecter gave to Clarice Starling in the 1991 movie, 'Silence of the Lambs':
Clarice Starling: Then tell me how.
Hannibal Lecter: First principles, Clarice. Simplicity. Read Marcus Aurelius.
Of each particular thing, ask:
'What is it in itself, what is its nature?'
What does he do, this man you seek?'
In other words, we must get the facts and try to see the obvious.
In the case of mutual funds, 'this man we seek', the fund manager, does exactly what he or she is told to do.
The fund manager invests in stocks, bonds, or whatever else is specified in the 'fundamental investment policy' of the fund.
It is the shareholder that makes the basic decision as to asset allocation.
Therefore, to fully explain fund behavior we must find out what motivates fund shareholders.
Before proceeding, check your progress:
Self-Test
In Capital Flow Analysis, we consider the ethical aspects of behavior because:
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To safeguard your job, your opinions regarding unethical behavior of a sector are best:
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If the stock market becomes over-valued, equity mutual fund managers can be expected to:
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